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Uncovering the Retail Bond Market

Elise Huttenga of lead manager IDCM discusses the appeal and growth of the retail bond
market.

The launch of the Orderbook for Retail Bonds (ORB) in February 2010 by the London
Stock Exchange (LSE) is seen by many as the catalyst for the development of a
retail bond market in the UK.

Since
its introduction just over 3 years ago, 26* new bonds have been launched,
specifically targeting retail investors looking to diversify away from equities
and earn higher yields than those they might realise from bond funds and bank
deposits.

(* This does not include a number of self
led / self-distributed issues by RBS, EIB issues and the HSBC Renminbi bond)

Since February 2010, the retail bond market has seen total issuance of £2.66bn,
£1.5bn of which was issued in 2012.

While ORB is technically a trading platform for stockbrokers and market
makers, its most interesting feature from an investor’s perspective is that it
significantly enhances transparency in what was, until recently, an
over-the-counter market.

On the dedicated ORB pages of the LSE website, two-way prices are shown for
some160 retail eligible bonds (legacy bonds that are tradable in small sizes as
well as the recent new issues). In addition, volume charts, transaction
details, documentation and other information for each bond are just a mouse
click away.

Spreading
debt maturities and refinancing risk

To
date, financial institutions have made up the bulk (40%) of the issuance in the
retail bond market – although 2012 and the first few months of 2013 saw greater
diversity among the issuers coming to market. A number of issuers have accessed
the retail bond market two or more times already including Provident Financial
Group, Lloyds, Tesco Personal Finance, Places for People and Intermediate
Capital Group.

Having built a loyal following, they have been able to raise
progressively larger transactions at increasingly attractive rates. Tesco Personal
Finance and Provident Financial in particular, have publicly stated that they
plan to return to this market on a regular basis, enabling them to spread their
debt maturities and their refinancing risk. In fact, Provident
Financial recently launched their 4th
retail bond.

As
many individual investors like to hold their bonds in a tax efficient wrapper
like an ISA or a SIPP, the minimum maturity of a retail bond is driven by the
ISA eligibility criteria which stipulate that at the time of purchase any
security needs to have a remaining maturity of at least five years.

Although most of the initial transactions were fairly short dated (only
just a few months longer than 5 years), issuers have successfully pushed the
boundaries of investor demand. In recent months, a number of borrowers have
issued bonds with 8 or 9 year tenors. In addition to offering borrowers the
flexibility to issue irregular tenors to suit their preferred redemption
profile, broken maturities are also possible. However, the sweet spot for
investor demand remains around seven years, as investors are looking for yield
but concerned about a sudden and significant rise in interest rates.

While
RPI-linked transactions were popular in 2011, demand for inflation protection
has waned and investors have demonstrated a clear preference for fixed-rate
coupons.

Price
discovery and performance

While
a number of discretionary wealth managers have mandates that require either the
issuer or the bonds to be rated, it appears that most individual investors are
indifferent to whether the issuer or the bond has a formal credit rating,
particularly if the issuer enjoys household name recognition and there is a
strong credit story that investors can easily understand.

At
the present time, name recognition and the perception of the issuer’s business,
scale and market profile still appear to be more important factors in many retail
investor’s credit assessment than the underlying credit quality or detailed terms
and conditions of the bond. However, as the number and diversity of credits
accessing his market increases, we would expect this to change, especially as market
participants become increasingly sophisticated and investors become more
selective in their investment choices. This development will benefit better
credits or those companies offering either security or appropriate and well
drafted covenants

The
significant drop in absolute yields, as well as the trickle-through demand from
what are largely ‘buy-and-hold’ investors, have caused the fixed-rate bonds to
perform particularly well in the aftermarket and many are now yielding circa
1-1.5% lower than at launch.

As a consequence of the strong performance of existing issues, we have also
seen some downward pressure on coupons, and in October 2012 the London Stock
Exchange (A- /Baa2 both on negative outlook) was the first issuer to break
through the physiological 5% minimum coupon threshold that had previously
existed. Although a number of issues now trade below 5.000% in the secondary
market, it is not necessarily possible for a comparable or the same issuer to
capture all of the benefit of that performance when launching a new issue.

Alternative funding for large and
medium capitalised borrowers

In
July 2012, Independent Debt Capital Markets (IDCM) opened up the retail bond
market for non-rated, non-household name, mid-cap companies with a £75m
transaction for Primary Health Properties (PHP). This ground breaking issue was
followed by transactions for unrated CLS Holdings (£65m) and Workspace (£57.5m),
St Modwen Properties (£80mn) and UNITE Group (£90mn).. For these borrowers the
retail bond market offers a way to diversify their funding in the debt capital
markets in ‘sub-benchmark’ size, i.e. smaller than required for an
institutional deal, without having to obtain a credit rating or provide
security.

Feedback from wealth managers and stockbrokers is that they are keen to see
more corporate borrowers coming to this market, ideally from different sectors and
indeed recent long dated issues from the London Stock Exchange (who raised
£300mn in October) and EnQuest (who raised £145mn in February of this year) have
met with strong investor demand.

Accessing the market

As the retail bond investor base is made up of self-invested
individuals, local IFAs, as well as nationwide stockbrokers and large private
wealth managers, the investor base is quite diverse in terms of the way they
assess credit, the speed at which they respond to new issues, and the magnitude
and importance of their order flow from a volume perspective.

Given this diversity, the large number of individual end-investors, the
granularity of orders and the multiple layers in the retail cascade, it is
crucial to understand what the market and private wealth managers in
particular, are looking for before launching a transaction.